China Kicks U.S. Private Equity Aside as Local Funds Rise

Yuan private-equity funds have raised $41 billion in the past two years, more than double the U.S. dollar amount in China, according to data from the Asian Venture Capital Journal. Photo: Nelson Ching/Bloomberg

May 15 (Bloomberg) -- Blackstone Group LP and TPG Capital
are among global firms being kicked aside as preferred investors
in China, the world’s second-biggest private-equity market.

Investments by Chinese firms rose to $7.8 billion last
year, exceeding for the first time the $7.4 billion poured in by
U.S. and other foreign funds, according to the Asian Venture
Capital Journal, which tracks the industry.

The shift to investors using Chinese currency has hastened
a 45 percent drop in investments by foreign funds last year,
even as the value of private-equity deals has doubled since
2009. It coincides with China’s stepped-up efforts to develop
home-grown firms, such as Beijing-based Hony Capital Ltd., and
as individuals and institutions pump money into a market that
favors the yuan, also known as renminbi, over the dollar.

“Renminbi fund managers have a huge advantage in terms of
speed of execution as well as easier exit opportunities within
China,” said Chris Meads, Hong Kong-based global head of
investment at Pantheon, a London private-equity company that has
invested $2.7 billion in Asia. “Deal flow is being diverted to
renminbi funds because it’s just easier for them to transact.”

Yuan private-equity funds have raised $41 billion in the
past two years, more than double the U.S. dollar amount in
China, according to the data from the venture-capital journal.
At the same time, foreign-currency funds focusing on China
slumped to $10.2 billion last year from $39.2 billion in 2007,
according to an April report by consulting firm Bain & Co.

Domestic Incentive

While the number of foreign-currency funds in China fell to
25 last year from 44 in 2008, domestic ones increased to 129
from 70, Bain said. Their average size more than tripled to $171
million from $54 million.

“If you’re an entrepreneur, you’ve got a choice between a
manager who requires a lot of approvals and has a long process,
versus a local manager whose cash is just as good but can do a
deal over the course of two or three weeks’ commercial due-diligence,” said Meads. “There is certainly an incentive for
the entrepreneur to favor the domestic renminbi manager.”

The Chinese government treats local companies that receive
U.S. dollars or other foreign currencies as foreign-invested
enterprises, which means additional layers of approvals from
regulators, even for actions such as opening a retail store,
which normally wouldn’t require clearance.

“Many Chinese companies realize taking money from any
foreign-currency fund will result in more restrictive scrutiny,
and they just can’t stand the red tape,” said Jessie Jin, a
Shanghai-based partner at GGV Capital in Menlo Park, California,
which has invested in companies including Alibaba Group Holding
Ltd. and online video operator Tudou Holdings Ltd.

Raising RMB

As the value of private-equity deals rises, increasing 19
percent to $28.5 billion last year and doubling since 2009, non-Chinese funds risk missing the party. In response, they’re
starting to compete by also raising renminbi funds.

Carlyle Group LP, the world’s second-largest private-equity
firm, was among the first to announce it had raised renminbi.
The company, based in Washington, raised 2.4 billion in the
first round of a yuan fund with Beijing’s municipal government
in July 2010, after setting up a $100 million joint fund with
Fosun Group in Shanghai five months earlier. Carlyle increased
the Beijing fund to 3.2 billion yuan in July last year.

Carlyle raised $671 million in an initial public offering
this month, pricing below its target after struggling to win
investors wary of the track record of buyout firms. Carlyle
shares closed yesterday 4.4 percent lower than the IPO price.

The firm is seeking capital for a buyout fund that will
invest in Asia, three people with knowledge of the matter said.

‘More Competitive’

Goldman Sachs Group Inc. announced its first yuan fund in
China last May, followed by Morgan Stanley a week later. In
February, TPG Capital, the Fort Worth, Texas-based buyout firm
started by David Bonderman two decades ago, said it raised 4
billion yuan in a first round of fundraising for its renminbi
fund, 90 percent coming from private investors in China.

“For the global players aiming for a large market share in
China, without renminbi funds, you probably feel more or less
insufficient in two or three years’ time,” said Eric Zhang, a
Beijing-based managing director at Carlyle. “Certainly it’s
much more competitive in the last year or two with many local
firms setting up.”

Whether renminbi investments by foreign managers are
treated the same as money from domestic private-equity funds is
subject to interpretation by local authorities. China hasn’t
formulated nationwide rules governing the private-equity
industry amid a lack of cooperation among regulators including
the National Development and Reform Commission, the China
Securities Regulatory Commission and the People’s Bank of China.

Pilot Project

A pilot project pioneered by the city of Shanghai hasn’t
cleared up the confusion. Blackstone was approved in 2009 to
start a 5 billion-yuan domestic fund, the first global firm to
get a go-ahead. The New York-based company expects to complete
its fundraising this year. When the program was announced in
2009, the Shanghai government said it would give non-Chinese
firms the same treatment as domestic yuan funds as long as they
received no more than 5 percent of their capital from overseas
private-equity funds registered in Shanghai.

In April, the NDRC overrode Shanghai authorities, issuing
policy guidelines that said Blackstone’s fund and those run by
foreign managers will be governed under foreign-investment
rules, even if they have 100 percent local funding, according to
a global fund executive who received the notice and asked not to
be identified because the statement wasn’t publicly released.

The rule has raised more uncertainty about foreign funds’
status in China, the person said. Hubert Tse, who advises funds
setting up in Shanghai under the program, said it leaves them
unlikely to gain local treatment.

Conversion Restrictions

“While the program rules suggest that those funds with
only local investors would be subject to national treatment, it
remains to be seen whether their investments would also be
treated as such by the relevant authorities outside of
Shanghai,” said Tse, a Shanghai-based partner in law firm Boss
& Young. “In practice, it’s very difficult to raise local
money, so almost all funds under this program would probably
still need to seek funding from overseas investors, so they are
deemed foreign funds in any case.”

Apart from investment restrictions, global funds also have
been vexed by currency-conversion restrictions, GGV Capital’s
Jin said. Companies receiving investments in foreign currencies
can’t exchange them for yuan all at once. They need separate
approvals to convert portions of those funds to pay employees or
buy equipment, she said.

Pulling Out

Smaller foreign-currency funds are hardest-hit by the
shift, and some are pulling out because there isn’t enough
appetite for dollar investments, said Tse, who’s advising an
overseas firm shutting a $200 million fund in China. He can’t
identify the fund because of client confidentiality, he said.

Many Chinese enterprises don’t think U.S.-dollar funds can
facilitate a stock listing in domestic markets, where valuations
are higher than abroad, said Steve Cai, president of Beijing-based Northern Capital Management Group, which raised a 300
million yuan private-equity fund in 2010 and has a $50 million
fund focusing on Hong Kong-listed companies.

The MSCI China Index, which tracks the performance of 564
companies listed in Shanghai or Shenzhen, is trading at 14 times
earnings, while the MSCI Hong Kong Index, which comprises 42
Hong Kong-listed Chinese stocks, is trading at nine times
earnings. Last year, Chinese companies’ overseas IPOs slumped 43
percent to $11.4 billion from 2009, while domestic offerings
rose 29 percent, data compiled by Bloomberg show.

Hony Capital

China has been building a domestic private-equity industry
to challenge the dominance of foreign firms. In 2006, the
government of the northeastern city of Tianjin set up Bohai
Industrial Investment Fund Management Co., whose shareholders
include China Life Insurance Co. and the nation’s social
security fund, as the first government-backed domestic private-equity fund with 20 billion yuan under management.

Hony Capital, sponsored by state-backed Legend Holdings
Ltd., has raised $6.8 billion since it was founded in 2003.
Citic Private Equity Funds Management Co., a unit of state-owned
Citic Group, China’s largest conglomerate, raised 9 billion yuan
since it was set up in June 2008 and is seeking to raise another
10 billion yuan in a second fund, as well as 5 billion yuan as
its first mezzanine fund, according to the company’s website.

Domestic private-equity firms have an edge over global ones
because they’re more focused in the country, said Hony Capital
Chief Executive Officer John Zhao, who raised 10 billion yuan
last year for the Beijing-based firm’s second renminbi fund,
doubling the size of a previous one in 2008.

Quicker Decisions

“Our decisions will be quicker” than foreign funds, Zhao
said, “with a sharper focus and better execution. The global
powerhouses can’t afford to spend as much time as we do in
China, as they have many markets to focus on.”

While renminbi funds are attractive to companies focusing
on the domestic market because such investments are “simpler,
faster and more certain,” Zhao said, entrepreneurs seeking to
expand beyond China’s borders, especially to list abroad, still
prefer U.S. dollar funds.

Executives from Carlyle and Goldman Sachs said some big
Chinese companies prefer to deal with well-known foreign
investors because of the help they provide in listing abroad, as
well as facilitating cross-border acquisitions and helping to
improve a company’s operations.

“To stay competitive, we need a local fund and a local
team, but we always have to deliver value on top of capital,”
said Stephanie Hui, a Hong Kong-based managing director at
Goldman Sachs’s private-equity unit.

Controlling Stakes

Executives at global private-equity firms say they’re
finding opportunities to invest in transactions that give them
control, exceling in an area in which many domestic renminbi
funds lack skills. Buyout deals in China more than doubled last
year, the highest level ever, according to Bain. Leveraged
buyouts increased to $7.5 billion from $5.9 billion in 2010,
according to Preqin Ltd., a London-based data provider.

Bain Capital LLC, the Boston private-equity firm co-founded
by Republican presidential candidate Mitt Romney, said last May
it would acquire Beijing-based China Fire & Security Group Inc.,
which makes fire-safety products and is traded on the Nasdaq
Stock Market, for $265.5 million. Two months later, Apax
Partners LLP, a London private-equity firm, bought all of
Shanghai-based restaurant chain Golden Jaguar for $250 million.

The Chinese government said in 2006 that overseas investors
needed Ministry of Commerce clearance to buy controlling stakes
in key industries, well-known trademarks or “old Chinese
brands.” It also has the power to veto or scale back deals
deemed to affect the “security” of China’s economy.

Foreigners Thwarted

The rules were triggered by lawmakers’ criticisms that the
government was selling assets on the cheap, after Goldman Sachs
bought 4.9 percent of Industrial & Commercial Bank of China
Ltd., the nation’s biggest bank, for $2.6 billion. The
investment has generated at least $2.4 billion in revenue for
the New York-based firm.

The ruling crimped overseas buyout funds. Carlyle was
forced to shelve a plan to buy control of China’s state-owned
Xugong Group Construction Machinery Co. in 2008, and its attempt
to buy part of Chongqing City Commercial Bank in 2007 failed to
win approval. Since then, global private-equity funds have
focused mostly on minority investments in private companies.

Blackstone has announced two investments in China since the
beginning of 2009, while TPG has four, Bloomberg data shows.

While the majority of the Chinese renminbi funds are
focusing on pre-IPO investments -- companies ready to sell
shares to the public within a year and yielding short-term
payout -- global firms put more emphasis on bigger transactions
that give them controlling rights, ranging from financial
decisions to operations, Carlyle’s Zhang said.

Joint Investments

Joint investments between foreign and domestic private-equity funds in China have become another way for foreigners to
gain market share, especially when it’s the local partner that
has access to opportunities. There were $13 billion of such
investments last year, more than double the $5.1 billion in
2010, the Asian Venture Capital Journal said.

“Certainly the space is still crowded, but there have also
emerged different deal types,” Zhang said, including those with
a controlling equity stake. “For the bigger-ticket deals, we
hope our renminbi and foreign funds work together and share the
team’s resources.”

Home-grown Chinese private-equity firms also are moving
into an area dominated by foreign investors: making overseas
acquisitions. In 2008, Hony Capital bought a stake of about 18
percent in Compagnia Italiana Forme Acciaio SpA, an Italian
machinery marker. A unit of Citic Private Equity teamed up in
January with Chinese construction-equipment maker Sany Heavy
Industry Co. to buy Aichtal, Germany-based concrete-pump maker
Putzmeister Holding GmbH for 360 million euros, or $475 million
at the time.

Raising Dollars

Chinese private-equity firms are raising U.S. dollar funds
as well, targeting companies in China seeking to expand in
overseas markets. About $3.4 billion was raised by domestic
firms last year, seven times more than 2009, according to the
Asian Venture Capital Journal.

Global private-equity firms dominated in China for most of
the past decade. Newbridge Capital LLC, which became the Asia
unit of TPG Capital in the 2000s, was the first foreign investor
to control a Chinese bank. Carlyle, which started in China in
1998, bought a 20 percent stake in China Pacific Insurance Group
Co. between 2005 and 2007, its biggest purchase in China.

Special Treatment

“All these guys enjoyed very good access in the market
before because there was no local competition,” Hony Capital’s
Zhao said. “What happened in the past years is that domestic
investors have the wallet, and China started to remove the
special treatment to foreign investors.”

China began eliminating tax incentives for foreign
companies in 2008 after its economy had grown about 90-fold in
three decades. In December 2010, the government started charging
foreign companies two taxes that domestic firms pay, according
to a statement by the State Administration of Taxation.

“Finally, a level-playing ground for both domestic and
international investors has emerged,” Zhao said.

While competition has intensified and global firms face
multiple bidders for good businesses in China, the number of
investable companies also is rising, said Goldman Sachs’s Hui.
Funds dedicated purely to China raised $23 billion last year,
second only to the U.S. with $40 billion, according Preqin.

The U.S. is the world’s biggest private-equity market with
about $150 billion of investments, according to data from the
Boston Consulting Group. China was second with about $30
billion, and the U.K. had $10 billion, the consulting firm said.

“There are still attractive deals for foreign investors in
China,” Pantheon’s Meads said. “They have to work a lot harder
than they have in the past to get them.”